Question

1. Interest Rate Risk

There are two bonds issued by Smith Inc. You buy one share of each by paying the market price. Ignore commission. The bond details are provided below:

-Bond Long: Face value = $1,000, Coupon = 9% annual, Price = $1,000, Maturity = 20 years.

-Bond Short: Face value = $1,000, Coupon = 9% annual, Price = $1,000, Maturity = 2 years.

The market interest rates suddenly drop by 2%. And you sell both the bonds. (Using Finance Calculator)

What is the profit (or loss) percentage realized for Long?

What is the profit (or loss) percentage realized for Short?

Answer 1

We calculate the price for the bond

Using a financial calculator

Bond Long

FV = 1000

I/Y = 7% ( Since the market rate drops by 2%, current yield = 9%-2% = 7%)

N = 20

PMT= 90 (9% coupon on $1000 face-value)

cpt PV, we get PV = $1211.88

Since the bond price has increased,

Profit realized for long = (1211.88-1000)/1000 = 0.21188

Profit realized for long = 21.19%

Bond Short

FV = 1000

I/Y = 7% ( Since the market rate drops by 2%, current yield = 9%-2% = 7%)

N = 2

PMT= 90 (9% coupon on $1000 face-value)

cpt PV, we get PV = $1036.16

Since the bond price has increased,

Profit realized for long = (1036.16-1000)/1000 = 0.03616

Profit realized for long = 3.616%